Transcript 8_AFPLST_Slides_Chapters_12_13

Chapter 12: Capital Markets
Outline:
 Overview of Capital Markets
 Debt Financing
 Equity (Stock) Securities
 Managing Capital Market Investments
 Valuation of Long-Term Securities
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Session 9: Module 5, Chapter 12 - 1
Discussion Question
What are the distinctions between money and
capital markets? Give examples of each.
Answer:
Money markets
 Money market instruments generally have ≤ 1 year to
maturity.
 Examples: T-bills, CP, repos and Bas.
Capital markets
 Capital market instruments are debt with
1 to 30+ years to maturity and equity securities
(no fixed maturity date but can cease to exist).
 Longer-dated capital market instruments are
usually marginally less liquid than money market
instruments.
 Examples: Bonds and common and preferred stock.
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Session 9: Module 5, Chapter 12 - 2
Key Participants
Issuers of securities
Central banks (debt)
Corporations
(debt and equity)
GSEs (debt)
Municipalities (debt)
Mutual fund companies
(debt and equity)
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Investors
Investment banking
and brokerage firms
Regulators
Rating agencies (debt)
Transaction
processors
Other parties
Session 9: Module 5, Chapter 12 - 3
Capital Markets
Primary
markets
Debt and equity offered to
investors; stock issues:
■ Initial public offering
■ Secondary issues
Secondary
markets
Existing debt and equity
traded by retail and
institutional investors
Private
markets
Securities offered and sold to
limited number of investors
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Session 9: Module 5, Chapter 12 - 4
Discussion Question
Identify the following market characteristics
as primary, secondary or private.
Answers:
Private
1. Issues may be exempt from SEC registration.
Primary
2. Underwritten issues provide funds to the
firm on the issue date; a syndicate markets
the issue to the investing public.
Secondary 3. Trades take place on stock
exchanges or over-the-counter
market.
Primary
4. Market price of existing shares
guides price for new shares.
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Session 9: Module 5, Chapter 12 - 5
Security Exchanges and Over-theCounter (OTC) Markets
Principal benefits:
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Competitive forces of
supply and demand
determine securities
prices
Market where frequent
trading minimizes price
volatility between
individual trades
Companies can raise
large amounts of capital
Regulated environment
to ensure fairness
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OTC markets:
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More decentralized
Rely on electronic
communication to
conduct auction-style
market trading
Unlike exchanges, may
trade government,
municipal and corporate
debt, equity
Session 9: Module 5, Chapter 12 - 6
Medium- and Long-Term
Borrowing

Term loan

Fixed maturity
typically > 1 year
 Specific need

Medium- or
intermediate-term
notes
2- to 10-year range
 Periodic interest
 Liquid
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Long-term bonds
10 to 30 years
 Customizable
 Coupon

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Session 9: Module 5, Chapter 12 - 7
Discussion Question
Which of the following describes a bond issue,
lists collateral, makes representations and
warranties, specifies covenants, specifies
terms by which a firm will provide funds for
redemption and sets forth interest payment
schedules or call provisions?
a) Guarantees
b) Indentures
c) Put provisions
Answer: b
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Session 9: Module 5, Chapter 12 - 8
Long-Term Bonds
Mortgage
bonds
Finance specific assets pledged as security;
usually include substantial covenants:
 Assets involved
 Right to issue additional bonds
 Use of second mortgages
 Sinking-fund, reporting, ratio requirements
 Prepayment terms
 Restrictions on dividend policy
Unsecured
bonds
General claims against assets or cash flows;
may be issued on subordinated basis.
Convertible
bonds
Corporate securities are convertible into
common/preferred stocks at a fixed price.
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Session 9: Module 5, Chapter 12 - 9
Long-Term Bonds
Stock purchase
warrants
Options to buy stock for a stated price
until a stated date.
Municipal
bonds
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General obligation bonds paid from
general tax revenues.
Revenue bonds paid from specific
public projects.
Zero-coupon
bonds
Pay no interest but sell at a deep
discount; no cash outflow until maturity
and deducts interest.
High-yield
bonds
Junk bonds; issued by less creditworthy
entities; imply a high required yield.
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Session 9: Module 5, Chapter 12 - 10
Other Bonds
Income bonds
Pay interest only if company has profits, reducing
risk for company
Collateral trust bonds
Backed by securities of other companies that are
owned by the issuing company
Equipment trust
certificates
Bonds secured with movable equipment (e.g.,
trucks, trains)
Index bonds
Interest rate tied to economic index; used in
countries with high inflation
Economic development
bonds
Issued by underdeveloped countries or by World
Bank or International Monetary Fund
Tax increment financing
(TIF) bonds
Used primarily for local financing; municipality uses
all or a portion to finance project
Tender option bonds
Allow the holder to sell them back to the issuer
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Session 9: Module 5, Chapter 12 - 11
Discussion Question
A bond that is denominated in U.S. dollars and
issued in India by a U.K. company would be an
example of a
a) foreign bond.
b) Eurobond.
c) global bond.
d) multicurrency bond.
Answer: b
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Session 9: Module 5, Chapter 12 - 12
Other Forms of Debt Capital
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Floating(adjustable-)
rate debt
Project financing
Securitization
Off-balancesheet financing
(leasing)
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Session 9: Module 5, Chapter 12 - 13
Debt Contract Provisions
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Bond indentures
and covenants
Representations
and warranties
Events of default
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Cure periods
Remedies
Waivers of defaults
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Refinancing
Defeasance of debt
Promissory note
Collateral
Liens
MAC clause
Call provisions
Sinking funds
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Session 9: Module 5, Chapter 12 - 14
Other Factors in Using Debt as a
Source of Capital
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Credit
enhancements
Guarantees
Bond ratings
Capital structure
considerations
Maturity
matching
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
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Effects of
interest rate
levels and
forecasts
Availability of
collateral
Session 9: Module 5, Chapter 12 - 15
Types of Guarantee of Principal
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Full guarantee
Specific project
guarantee
Guarantee of payment
or collection
Comfort letter
Performance guarantee
Personal guarantee
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Session 9: Module 5, Chapter 12 - 16
Equity (Stock) Securities
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Common stock
Preferred stock
Hybrid securities
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Convertibles
Warrants
International
equity market
Depository
receipts (DRs)
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Session 9: Module 5, Chapter 12 - 17
Discussion Question
What are some of the benefits of using
depository receipts (DRs), especially for
companies in countries with limited financial
markets?
Answer:
 They help increase global trade, including
transaction volumes on both local and foreign
markets.
 They offer greater exposure and the
opportunity to raise capital on a global basis
to companies in smaller countries.
 They help reduce market inefficiencies,
especially in emerging markets, by allowing for
easier global investment in those markets.
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Session 9: Module 5, Chapter 12 - 18
Types of Common Stock
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Most companies have only
one class.
Different classes may limit
voting privileges,
dividends and/or resales.
Tracking stock.
Institutional investors own
70% of all common stock.
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Session 9: Module 5, Chapter 12 - 19
Objectives of Capital Market
Investments
Return
objective
Risk
tolerance
Investment
policy
Some mix between current
income and capital
appreciation
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Issues to consider:
 Risk preferences
for portfolio
 Return objectives
 Liquidity needs
 Time horizons or
future needs for
funds
 Tax issues
 Legal or
regulatory factors
Session 9: Module 5, Chapter 12 - 20
Capital Asset Pricing Model (CAPM)

Beta (ß) measures the risk of a particular stock relative to
overall market. The market has a beta of one, so stocks with
a beta > one are more risky than the market; those with a
beta < one are less risky than the market. Risk-free assets
(T-bills) have a beta of 0. Assume that the T-bill rate is 2%,
the expected rate of return on the market portfolio is 8%,
and the beta for this stock is 1.5 (greater risk than average).
rE = rRF + (rM  rRF )ßi
Where:
= 0.02 + (0.08  0.02) 1.5  = 0.110 or 11.0%
rE = Required rate of return on stockholder's equity
rRF = Expected rate of return on risk-free asset (T-bill rate)
rM = Expected return on market portfolio (S&P 500 index)
ßi = Beta value for stock i
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Session 9: Module 5, Chapter 12 - 21
Preferred Stock Valuation
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Preferred stock is viewed as an annuity that
exists into perpetuity.
Example: $50 par value; pays a 6.60%
annual dividend; market requires 8% return.
Preferred Stock Dividend = Preferred Stock Dividend Rate  Par Value
= 6.6%  $50
= 0.066  $50.00 = $3.30
Preferred Stock Annual Dividend
Price of Preferred Stock =
Required Rate of Return
$3.30
=
= $41.25
0.08
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Session 9: Module 5, Chapter 12 - 22
Common Stock Valuation
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Both timing and amount of cash flows from common
stock can vary.
Following equation assumes that dividends will grow
at a constant rate in the future. Required rate of
return can be determined using CAPM.
Example:

P0 = Current value of the stock
D1 = Next expected dividend
(calculated as D0[1+g])
P0
 Next dividend (D0): $2.00
 Estimated dividend growth
rate (g): 6%
 Required rate of return for the
stock (ks): 13%

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D0 1 g
D1
=
=
k s  g k s  g
$2.00 1 0.06 $2.12
=
=
= $30.29
0.13  0.06 0.07
Session 9: Module 5, Chapter 12 - 23